Growth in Islamic finance to benefit the offshore world

Islamic finance constitutes one of the fastest growing parts of the global financial services industry. Still considered to be in its infancy compared with the global financial industry, Islamic finance accounts for assets worth up to US$700b across 300 financial institutions based in 75 countries, working according to Islamic principles. The sharia-law-compliant Islamic bond – or Sukuk – market had, until 2008, doubled in value every year since 2004. Although the Sukuk market suffered a sharp drop in the value of issuances in 2008 (down 54.5 per cent from 2007 to US$15.1b), there was a rise in the number of Sukuk issuances during 2008 – measured in 165 issuances as compared with 129 in 2007.

It should be no surprise that the international financial crisis has been cited as the main factor in the recent drop in Sukuk issuance values. Although S&P’s has reported that it does not expect the Sukuk market to start reviving before the second half of 2009 or early 2010, it and other players in the industry believe that the long-term prospects for Islamic finance generally, and particularly Sukuk issuances, remain good.

Aside from the desire of issuers to seek much needed funding from Islamic financial institutions and Middle Eastern investors, much of the reason for this positive outlook derives from the principles that form the basis of Islamic finance which, it is claimed, largely insulate the industry from many of the issues that gave rise to the credit crisis. Islamic banks are more conservative than conventional banks in terms of financing. As they are required to conduct a more thorough scrutiny of the assets against which they lend, it is more difficult for them to use leverage and they are obliged to share profits and losses with investors. Under the principles of Islamic law or sharia, moneys cannot be used to finance activities that are haram (that is forbidden under Islamic law), such as gambling, guns and alcohol. Derivatives used as a means of pure speculation are, therefore, not permitted and most Islamic finance transactions are required to be asset-based, in other words, have a real underlying asset or productive commercial activity.

Despite the state of the global economy, there continues to be increased demand for Islamic financial products with Islamic banks planning new branch openings and expansions in 2009 and many Sukuk issuances in the pipeline. It is hoped that this should lead to greater exposure for offshore centres that are used in structuring popular Islamic financial products.

 

Use of offshore structures in Islamic finance

The Middle East and Asia have for many years used offshore centres to organise investments and structure personal wealth, so it was a natural progression for these offshore jurisdictions to be used in the structuring of sharia-compliant transactions such as Sukuks and Islamic funds. Practitioners, particularly lawyers, in these regions as well as other parts of the world were familiar with the cost, tax, legal and regulatory efficiencies of using offshore jurisdictions in structuring complex financial products and the offshore centres have been keen to market their value to the development of the new wave of Islamic financial products.

The Middle East and Asia have for many years used offshore centres to organise investments and structure personal wealth, so it was a natural progression for these offshore jurisdictions to be used in the structuring of sharia-compliant transactions such as Sukuks and Islamic funds. Practitioners, particularly lawyers, in these regions as well as other parts of the world were familiar with the cost, tax, legal and regulatory efficiencies of using offshore jurisdictions in structuring complex financial products and the offshore centres have been keen to market their value to the development of the new wave of Islamic financial products.

Sukuk transactions

Traditional interest-bearing instruments contravene Islamic prohibitions on interest or usury. Sukuk instruments have been structured to comply with sharia and, as reflected above, have become an important tool for raising finance in the Islamic world.

Sukuk are typically structured as trust instruments under English law. A company will issue Sukuk, or trust certificates, and invest the proceeds in assets. The issuer of the Sukuk will then hold the assets on trust for the benefit of the holders of the Sukuk, using the income from the assets to make payments to the Sukuk holders.

The wider Sukuk structure can be more complex with a few more players involved. Typically, the entity looking to raise funds – often referred to as the obligor – will establish a company to act as issuer of the Sukuk. The obligor will then, for example, either sell or lease its assets to the issuer. The issuer will purchase the assets or lease them with the proceeds from the issue of the Sukuk. The issuer will then make periodic payments back to the Sukuk holders from proceeds generated by the assets, often by leasing them back to the obligor. At the end of the transaction, the issuer will sell the assets back to the obligor and use the proceeds to redeem the Sukuk. There are several variations to this structure, with the issuer leasing, buying or entering a joint venture to buy and manage the assets from the obligor but the cashflows generally follow the same pattern.

To those looking at this structure from the offshore industry, it will look very similar to a securitisation structure. All of the benefits that attracted the securitisation industry to establish bond issuers in offshore jurisdictions would also apply to the Sukuk issuer. The Cayman Islands, in particular, was quick to market its services for Sukuk structures as a domicile for the issuer, an initiative that achieved considerable success. At first, the opportunity was simply for the Cayman Islands law firms to establish a Cayman Islands company to act as issuer (sometimes referred to as a special purpose vehicle or SPV), typically a subsidiary of the obligor managed by the obligor. However, this was deemed too synthetic, effectively the obligor was selling assets to itself (or at least a wholly owned subsidiary) and most sharia scholars require some distance between the obligor and the issuer. This again created a great opportunity for the offshore service providers to establish and manage the Sukuk issuer for the duration of the Sukuk transaction.

The typical structure of an offshore Sukuk issuer is a limited liability company with its shares held by a trust company on trust for charitable purposes. A corporate services provider (usually the same trust company) will then provide the company with a registered office and directors to maintain the company, obviously for a fee. The services from the corporate services provider may also extend to preparing accounts, arranging audits and/or providing a corporate secretary. The result is a legal entity independent of the obligor that can deal with the obligor at arm’s length.

Cayman regulators focused on Islamic finance market

As evidence of its commitment to maintain the title of offshore jurisdiction of choice for Islamic finance, the Cayman Islands has responded to the requirements of the expanding Islamic financial market by revising its corporate registry system and pertinent legislation.

In March 2007, the General Registry of the Cayman Islands government introduced an Arabic language facility that allows companies to register their names in Arabic and English (and to receive certificates which bear their names in both languages), reflecting the Cayman Islands Government’s recognition of the importance of the growing Islamic finance market.

In August 2008, the Cayman Islands introduced amendments to the Mutual Funds Law and the Banks and Trust Companies Law specifically to deal with the regulatory status of Sukuk. The amendments clarify that Sukuk instruments are alternative financial investments falling outside of the scope of such laws, an approach that is consistent with international stock exchanges and the accounting rules applied to Sukuk instruments.

Prior to the introduction of these amendments, there were two regulatory concerns under Cayman Islands law. First, in Sukuk structures where it was proposed that the Sukuk be redeemable at the option of the investor, it was arguable that the issuer could be considered a mutual fund (as Sukuk are structured as trust instruments) requiring it to be regulated as such under the Mutual Funds Law. Second, where institutions sought to replicate multi-issuance programmes, it was arguable that the issuer could be deemed to be conducting trust business (as the issuer holds assets on trust for the benefit of the Sukuk holders) requiring it to obtain a trust licence under the Banks and Trust Companies Law.

These legislative amendments create legal certainty and efficiency for those seeking to issue Sukuk instruments, particularly when structuring redeemable and multi-issuance Sukuk transactions and should ensure that the Cayman Islands remains retains its appeal for Islamic finance structures.

Conclusion

The global credit crisis has turned the world’s attention toward Islamic finance. Several countries, including non-Muslim countries such as the UK, are committed to developing their own Islamic finance market and others, such as the US, are eager to learn more about Islamic finance. The industry is focusing on the development of standardised regulations and documentation for Islamic financial products, which is critical to the growth and success of global Islamic financial markets. The offshore centres have been keen to market their services for and to play a role in the development of Islamic financial products. Offshore law firms and service providers have opened offices in the Middle East displaying their commitment to the region and to Islamic finance. Several offshore centres, particularly the Cayman Islands, should continue to benefit from this focus as we look forward to a stronger and globalised Islamic financial services industry in the years to come. 

Dubai_Marina

Dubai Marina, in the distance you can see Sheikh Zayed Road and Jumeirah Lake Towers
SHARE
Previous articleCorruption and the Bribery Bill 2009
Next articleThe future of the Cayman financial industry
Tahir Jawed

Tahir Jawed joined Maples and Calder in Cayman in 2000 making partner in 2005. Now managing partner of the Dubai office, he worked for Clifford Chance in London, New York and Dubai. Mr Jawed specialises in offshore structuring of Islamic finance products and participated in the first Sukuk issue by a Cayman company to be listed on DIFX and the inaugural Sukuk issues listed on other worldwide exchanges.

Tahir Jawed
Partner
Maples and Calder
Fifth Floor, The Exchange Building
Dubai International Financial Centre
PO Box 119980
Dubai
United Arab Emirates

T. + (971) 4 360 4071
E. tahir.jawed@maplesandcalder.com
W. www.maplesandcalder.com 

Manuela Belmontes

Manuela Belmontes joined Maples and Calder in 2007 after stints at Turner & Roulstone in the Cayman Islands, Clifford Chance in London and Blake, Cassels & Graydon in Canada. She specialises in structured finance and international capital markets and has also provided advice to Cayman investment funds, investment managers, administrators and trustees.

Manuela Belmontes
Associate
Maples
Fifth Floor, The Exchange Building
Dubai International Financial Centre
PO Box 119980
Dubai
United Arab Emirates

T. + (971) 4 360 4074
E. manuela.belmontes@maplesandcalder.com
W. www.maplesandcalder.com